Tuesday, January 22, 2013

The Treasury and IRS have adopted final
regulations implementing the Foreign Account Tax Compliance Act (FATCA). The regulations
provide additional certainty for financial institutions and government
counterparts by finalizing the step-by-step process for U.S. account identification, information
reporting, and withholding requirements for foreign financial institutions, other
foreign entities, and U.S.
withholding agents.

The final regulations also build on
intergovernmental agreements the U.S.Treasury has entered into with foreign
governments to facilitate the effective and efficient implementation of FATCA
by eliminating legal barriers to participation, reducing administrative
burdens, and ensuring the participation of all non-exempt financial
institutions in a partner jurisdiction. In order to reduce administrative
burdens for financial institutions with operations in multiple jurisdictions,
the final regulations coordinate the obligations for financial institutions
under the regulations and the intergovernmental agreements.

Passed
in 2010 as part of the Hiring Incentives to Restore Employment Act (HIRE),
FATCA creates a new reporting and taxing regime for foreign financial
institutions with U.S.
accountholders. FATCA adds a new Chapter 4 to the Internal Revenue Code,
essentially requiring foreign financial institutions to identify their
customers who are U.S. persons or U.S.-owned foreign entities and then report
to the IRS on all payments to, or activity in the accounts of, those persons.

The
Act broadly defines foreign financial institution to comprise not only foreign
banks but also any foreign entity engaged primarily in the business of
investing or trading in securities, partnership interests, commodities or any
derivative interests therein. According to the Joint Committee on Taxation,
investment vehicles such as hedge funds and private equity funds fall within
this definition. Firms meeting the definition must enter into agreements with
the IRS and report information annually in order to avoid a new U.S.
withholding tax.

The final regulations broadly define
financial institution and investment entities to effectuate the purposes of the
Act to effectively and efficiently combat offshore tax evasion. The regulations define a financial
institution as, among other things, an investment entity which, in turn, is
defined as an entity that primarily conducts as a business one or more of the
following activities or operations for or on behalf of a customer: (1) Trading
in money market instruments (checks, bills, certificates of deposit, derivatives, etc.); foreign currency;
foreign exchange, interest rate, and index instruments; transferable securities;
or commodity futures; (2) Individual or collective portfolio management; or (3)
Otherwise investing, administering, or managing funds, money, or financial
assets on behalf of other persons. Moreover, the entity functions or holds
itself out as a collective investment vehicle, mutual fund, exchange traded
fund, private equity fund, hedge fund, venture capital fund, leveraged buyout
fund, or any similar investment vehicle established with an investment strategy
of investing, reinvesting, or trading in financial assets. Reg. § 1.1471-5(d).

The legislation’s principal focus is tax
compliance by U.S.
persons that have accounts with foreign financial institutions. The Act imposes
substantial new reporting and tax-withholding obligations on a broad range of
foreign financial institutions that could potentially hold accounts of U.S.
persons. The reporting and withholding obligations imposed on the foreign
financial institutions will serve as a backstop to the existing obligations of
the U.S. persons themselves,
who have a duty to report and pay U.S. tax on

the income they earn through any financial
account, foreign or domestic. These new reporting obligations for financial
institutions will be enforced through the imposition of a 30-percent U.S. withholding tax on a wide range of U.S.
payments to foreign financial institutions that do not satisfy the reporting
obligations. The legislation provides substantial flexibility to Treasury and
the IRS to issue regulations detailing how the new reporting and withholding
tax regime will work. It also gives Treasury broad authority to establish
verification and due-diligence procedures with respect to a foreign financial
institution’s identification of any U.S. accounts.

Chapter 4 also provides for withholding taxes
as a means to enforce new reporting requirements on specified foreign accounts
owned by specified U.S.
persons or by U.S.-owned foreign entities. The provision establishes rules for
withholdable payments to foreign financial institutions and for withholdable
payments to other foreign entities. The Act essentially presents foreign
financial institutions, foreign trusts and foreign corporations with the choice
of entering into agreements with the IRS to provide information about their U.S.
accountholders, grantors and owners or becoming subject to 30-percent
withholding.

The legislation’s principal goal is to
collect tax from .S. taxpayers who have evaded their responsibilities by
investing through foreign financial institutions and foreign entities not
subject to IRS reporting obligations. To achieve this goal, the legislation
imposes the risk of a withholding tax on a broad class of
U.S.-related payments (including gross proceeds) to a broad class of foreign
investors, unless the foreign financial institutions and foreign entities agree
to provide information to the IRS regarding their U.S. account holders and owners. Essentially, the withholding tax will
function as a “hammer” to induce reporting.

Many of the foreign financial institutions
that hold accounts on behalf of U.S.
persons fall outside the reach of U.S. law. As a result, the current
ability of the United States
to require foreign financial institutions to disclose and report on U.S.
account holders is significantly limited. Although these foreign
financial institutions are outside the direct reach of U.S. law, many of them have substantial
investments in U.S. financial
assets or hold substantial U.S.
financial assets for the account of others.

The federal government imposes a tax on the beneficial
owner of income, not its formal recipient. For example, if a U.S. citizen owns securities that are held in
street name at a brokerage firm, that U.S. citizen (and not the
brokerage-firm nominee) is treated as the beneficial owner of the securities. A
corporation (and not its shareholders) ordinarily is treated as the beneficial owner of the
corporation’s income. Similarly, a foreign complex trust ordinarily is treated
as the beneficial owner of income that it receives, and a U.S. beneficiary or grantor is not
subject to tax on that income unless and until he or

she receives a distribution.

Under FATCA, the financial world
is essentially divided into foreign financial institutions and US financial
institutions. US financial institutions have the first compliance obligations
under FATCA as the primary withholding agents for withholdable payments made to
foreign financial institutions. IRS Notices 2010-60 and 2011-34 provide details
regarding how participating foreign financial institutions must identify,
report, and withhold on their accounts, and how US financial institutions must
identify and withhold on some payments to foreign financial institutions, many
details regarding US financial institutions have not yet been provided.

The Act imposes a 30-percent withholding tax
on certain income from U.S.
financial assets held by a foreign financial institution unless the foreign
financial institution agrees to: (1) disclose the identity of any U.S.
individual that has an account with the institution or its affiliates; and (2)
annually report on the account balance, gross receipts and gross withdrawals and payments from the
account foreign financial institutions also must agree to disclose and report
on foreign entities that have substantial U.S. owners. These disclosure and
reporting requirements are in addition to any requirements imposed under the
Qualified Intermediary program. It is expected that foreign financial institutions will comply with these
disclosure and reporting requirements in order to avoid paying this withholding
tax.

In addition to requiring 30-percent
withholding on the expanded category of withholdable payments for financial
institutions that do not enter into an agreement with the IRS, new Internal
Revenue Code Section 1474(b)(2) will deny a credit or refund to a foreign financial institution that is the beneficial
owner of a payment except to the extent that the firm is eligible for a reduced
treaty rate of withholding. The section will also deny interest on refunds.

The agreement between the IRS and the foreign
financial institution must contain several provisions. Specifically, the
foreign financial institution must obtain information regarding each holder of each account
maintained by the firm as is necessary to determine which accounts are U.S. accounts, to comply with verification and
due-diligence procedures with respect to the identification of U.S.accounts,
and to report annually information with respect to any U.S. account maintained by the
firm. The foreign financial institution must also deduct and withhold 30 percent
from any pass-through payment that is made to a recalcitrant account holder or
another financial institution that does not enter into an agreement. A
pass-through payment is any withholdable payment or payment that is
attributable to a withholdable payment.

A “recalcitrant account holder” is defined as
any account holder that fails to comply with reasonable requests for
information necessary to determine if the account is a U.S. account; fails to
provide the name, address, and TIN of each specified U.S. person and each
substantial U.S. owner of a U.S. owned foreign entity; or fails to provide a
waiver of any foreign law that would prevent the foreign financial institution
from reporting

any information required under this provision.

The Act adds a new Section 1472 to the
Internal Revenue Code to deal with withholdable payments to non-financial
foreign entities, which it defines as any foreign entities that are not
financial institutions. Specifically, the legislation requires a withholding
agent to deduct and withhold a tax equal to 30
percent of any withholdable payment made to a non-financial foreign entity if
the beneficial owner of the payment is a non-financial foreign entity that does
not meet specified requirements.

A non-financial foreign entity meets the
requirements of the provision, and payments made to it will not be subject to
the imposition of 30-percent withholding tax, if the payee or the beneficial owner of the
payment provides the withholding agent with either: (1) a certification that
the foreign entity does not have a substantial U.S. owner; or (2) the name, address and TIN of each
substantial U.S.
owner.

The Act defines a “substantial U.S. owner” as
a person who owns more than ten percent of the company’s stock or is entitled
to more than ten percent of the profits in a partnership. In the case of an
investment firm, however, that limit is reduced from ten percent to zero. Additionally,
the withholding agent cannot know or have reason to know that the certification
or information provided regarding substantial U.S. owners is incorrect, and the
withholding agent must report the name, address and TIN of each substantial
U.S. owner to the Secretary.

The legislation provides a carve-out for
corporations whose stock is regularly traded on an established securities
market. The carve-out is presumably based on a congressional belief that the
risk of tax evasion in connection with a publicly-traded corporation is low. Similarly,
the legislation provides a carve-out for charitable and other organizations
that are exempt from tax under IRC Section 501(a), again presumably because
these entities pose a low risk of being used to facilitate U.S.
tax evasion. A further carve-out is provided for SEC-regulated investment
companies.

Due Diligence

The final regulations phase in over an
extended transition period to provide sufficient time for financial
institutions to develop necessary systems. In addition, to avoid confusion and unnecessary duplicative
procedures, the final regulations align the regulatory timelines with the
timelines prescribed in the intergovernmental agreements. The final regulations
allow reasonable timeframes to review existing accounts and implement FATCA’s
obligations in stages to minimize burdens and costs consistent with achieving
the statute’s compliance objectives.

To limit market disruption, reduce
administrative burdens, and establish certainty, the final regulations provide
relief from withholding with respect to certain grandfathered obligations and
certain payments made by non-financial entities.

To better align the obligations under FATCA
with the risks posed by certain entities, the final regulations expand and
clarify the treatment of certain categories of low-risk institutions, such as
governmental entities and retirement funds. They also provide that certain
investment entities may be subject to being reported on by the FFIs with which
they hold accounts rather than being required to register as FFIs and report to
the IRS. The regulations also clarify the types of passive investment entities
that must be identified and reported by financial institutions.

The final regulations provide more streamlined
registration and compliance procedures for groups of financial institutions,
including commonly managed investment funds, and provide additional detail
regarding the obligations of foreign financial institutions to verify their
compliance under FATCA.